Speech
Non-mining Business Investment – Where to from here?

Introduction

I'd like to thank Bloomberg for the opportunity to talk to you today. I discussed
this topic at this same venue 18 months ago. The outlook for non-mining business
investment is an important element of our forecasts. It depends on a range
of forces acting on the economy, including the stimulus currently being provided
by the very low level of interest rates. But, forecasting economic activity
is hard. Understanding and forecasting business investment is arguably harder
still.

When I was here in April of last year, I'd suggested that:

mining investment would be likely to peak in 2013;

non-mining investment would be likely to pick up, but only gradually; and

growth for the economy as a whole would be a little below trend in 2013 and then
pick up gradually through 2014.

It now looks like mining investment peaked in late 2012 (Graph 1). Despite a
substantial decline in mining investment since then, growth of the economy
overall picked up to a pace that was around trend over the course of the past
year. Much of that improvement has owed to a sharp rise in resource exports.

At the same time, there has also been an improvement in the growth rate of economic
activity in the non-mining sectors, even though non-mining business investment
has remained subdued. This better growth of non-mining activity often gets
missed given all the focus on the resources boom. While this improvement is
welcome, a key question is how durable the improvement will be? It might even
gather a bit more steam, thereby helping to drive overall growth to an above-trend
pace at some point. Such developments are possible but by no means certain.
They depend in part on non-mining business investment, which is the motivation
for my talk today.

Graph 1

Recent Past

Over recent years, non-mining business investment has been subdued. After recovering
from the decline that followed the global financial crisis, non-mining business
investment in real terms has been little changed over the past three years
or so (Graph 2). In nominal terms, non-mining business investment is at
a very low level as a share of GDP relative to its history.[1]

Graph 2

Non-mining business investment should depend, in large part, on the strength of expected demand in the non-mining sectors of the economy (over the
life of that investment). Current demand conditions, however, may have a strong
influence on investment for two reasons. First, firms tend to draw on recent
experience when assessing prospects for future demand. Second, stronger sales
today will boost current cash flows, which will assist firms facing financial
constraints.

Hence, the gradual pick-up in the growth of non-mining economic activity over the
past year augurs well for investment. Low interest rates and robust population
growth are underpinning strong demand in the housing market, with house prices
rising rapidly and dwelling investment picking up strongly. Low interest rates
are also supporting growth of consumption at a time when subdued conditions
in the labour market are weighing on the growth of incomes. These developments,
as well as growth in export industries such as tourism and education, are consistent
with a pick-up in business conditions across a range of industries.

Despite these gains, survey measures of non-mining capacity utilisation have not
improved much over the past year. A measure derived from the NAB survey (based
on weighting industries according to their contribution to investment) implies
that capacity utilisation remains a bit below average (Graph 3). By itself,
this suggests that demand in the non-mining sector will need to rise a little
further before businesses feel the need to undertake substantial investment
in new capacity. Our forecasts for the economy suggest that this will occur
in time, but the extent and timing of new investment remains uncertain.

Graph 3

It's Not Just Output/Demand that Matters

In addition to the strength of demand, a range of other factors also influence investment
decisions. In particular, investment depends on whether the expected return
to new capital outweighs the cost of installing it. In other words, a firm
should invest whenever the market value of its existing capital is greater
than its book value. This is known, in academic circles, as Tobin's Q theory
of investment, where Q is the ratio of the market value to the book value of
capital.

It turns out that empirical support for the relationship between investment and the
Q-ratio is weak for the economy as a whole.[2]
However, it is possible to show that such a relationship exists at the level
of individual firms (Graph 4). Estimates from Tobin's Q type models
based on Australian firm-level data indicate that non-mining investment has
been unusually weak by historical standards in recent years. This is true after
controlling for many other factors typically included in such models, such
as sales growth and cash flows. For firms in the Bank's liaison program,
it also appears that investment has been weaker than the recent growth in sales
would suggest.

Graph 4

With that in mind, let's consider some possible explanations for the weakness
in non-mining business investment, and what that might imply for the outlook.

The cost of borrowing remains too high and external
finance is difficult to access?

My discussion so far has ignored the fact that firms face financing constraints of
varying degrees and certain types of finance are more costly to obtain than
others. In particular, the cost of external equity finance is typically greater
than the cost of external debt which, in turn, is greater than the cost of
internal funding.

Financial constraints certainly became more pervasive for many firms as the global
financial crisis unfolded. However, those constraints have eased over time.
More recently, external financing has become widely available at very favourable
cost. Primarily, this reflects the stance of monetary policy (both in Australia
and abroad), which is delivering historically low levels of interest rates,
ample liquidity and has helped to push up equity prices.

Indeed, a common refrain of firms in the course of our business liaison has been
that neither the cost nor the availability of external finance have been factors
limiting investment of late. Moreover, (non-financial) corporate balance sheet
data indicate that many Australian companies currently hold relatively high
levels of cash, suggesting that they have access to resources to finance investment
when the time comes.

The exchange rate is too high?

The exchange rate has declined somewhat relative to its peak in the first half of
2013. But it remains high, especially given the sizeable decline in commodity
prices this year. The implications of this vary across traded and non-traded
sectors.

A further decline in the exchange rate would provide additional support to demand
for domestic firms producing tradable goods and services. At the same time,
however, the high exchange rate also means that imported capital goods are
currently relatively cheap.

Hence, the still-high level of the exchange rate may be a net positive factor for
the investment plans of some firms in non-tradable industries. For firms in
tradable industries, on the other hand, the low cost of imported capital is
offset by the effect of the high exchange rate on the demand for the goods
and services they produce.

In short, the high exchange rate might be playing a part in restraining investment
in some sectors of the economy, but it's unlikely to be the full story.

Animal spirits are too weak?

What is often referred to as ‘animal spirits’ consists of three key elements.[3]
First, there is uncertainty, which describes the range of possible outcomes,
let's say for demand, but other things like costs matter too. Second, there
is the expected or most likely outcome. Together, these describe the distribution
of possible outcomes. But firms' willingness to invest also depends on
the third element, which is their appetite for risk. I'll consider each
of these elements in turn.

The outlook is too uncertain?

On the surface, uncertainty seems like an appealing explanation for subdued investment.
However, we should remember that firms always have to make investment decisions
in an environment of uncertainty, not just about the prospects for the macroeconomy
but also for their industry. Rather, the question we need to ask is whether
uncertainty in recent years has been elevated?

There are a number of ways that we might try to measure the extent of uncertainty.
One measure is the volatility of firms' share prices (Graph 5).[4]
Another is the dispersion of analysts' forecasts of firms' earnings
(per share). A third can be constructed by looking at the proportion of news
stories that mention uncertainty.[5]
These measures all increased at the time of the global financial crisis. All
of the measures have since declined to be around the levels seen prior to the
financial crisis, when non-mining business investment had been growing strongly.[6]

Graph 5

Expectations regarding demand are too weak?

Even if uncertainty about the range of possible demand outcomes is not too different
from the past, the most likely outcome – the mean of the distribution
– might still be too weak to lead to significant new investment projects.

Business surveys ask firms what they expect conditions will be like in the near future;
the results are described as ‘business confidence’. The long-running
NAB survey suggests that business confidence was in decline and below its long-run
average up to the middle of last year (Graph 6). Since then, it has picked
up noticeably. This improvement was shortly followed by a broad-based pick-up
in the survey's measure of actual business conditions (that is, trading
conditions, profits and employment). According to the NAB survey, and a number
of other business surveys, business confidence and conditions are now above
average.

Graph 6

However, our liaison program suggests that businesses generally remain reluctant
to take on significant new investment projects until they can be confident
of a more sustained improvement in demand conditions. How long do conditions
need to hold at above average levels before the improvement is considered to
be sustainable?

We don't know the answer to this. In part, this is because animal spirits are
by no means mechanistic or predictable. What matters for your investment plans
is not just what you think about the future, but what you think your competitors
think about the future. In part, this is because if your competitors are less
than enthused about investing, the pressure for you to invest to avoid being
left behind is lessened, and vice versa.

Elevated risk aversion?

Even though measures of uncertainty appear to have declined, and firms' confidence
about future business conditions is above average, firms' investment plans
may sit idle if they are more risk averse than in the past. (By firms, I mean
both managers and shareholders alike.)

It's clear that firms became more risk averse at the onset of the global financial
crisis. It seems that they remain affected by that experience. While the direct
effects of the crisis on the Australian economy were generally short-lived
and relatively minor compared with the experience of many economies, the events
of that time led many Australian businesses and households to re-evaluate their
appetites for risk. The household sector increased its saving rate noticeably
at the time of the crisis and it remains around the more prudent levels that
had been the norm in earlier decades.[7]
Also, businesses deleveraged and have built up their levels of cash holdings.

One measure of firms' appetite for risk is their ‘hurdle’ rates of
return. These serve as rules of thumb for firms to evaluate whether or not
to proceed with a particular project. The higher the hurdle, the less likely
any given project will be given the go ahead. There is no evidence that hurdle
rates of return have increased over recent years. But neither is there evidence
that they have declined even though the average cost of capital for firms has
fallen.[8]
This larger gap between the hurdle rates and the average cost of capital implies
a reduction in firms' appetite for risk. This result, which is consistent
with information from our liaison program, appears to be a global phenomenon.

Our liaison provides other evidence of a more cautious approach to investment over
recent years. In particular, many firms now require investment projects to
satisfy shorter payback periods and be approved at higher levels of management
than was typical in the past.[9]

Other Longer-term Determinants?

The current weakness in non-mining business investment may reflect the effect of
some longer-run determinants of investment. One such candidate is (multifactor)
productivity growth. Relatively weak growth of productivity over much of the
past decade would have weighed on the return to capital and reduced the incentives
to add to the capital stock in non-mining industries (Graph 7). (In principle,
this effect should already be reflected in levels of Tobin's Q.)

If productivity growth were to remain relatively low, that would weigh on overall
growth of the economy. Low growth of investment would naturally follow from
low productivity growth, but it would not be the cause of weak growth of the
overall economy. In any case, it's hard to know exactly what productivity
growth is likely to do in the future. More recently, multifactor productivity
growth appears to have increased a little. It is currently not far from growth
rates seen prior to the mid 1990s, which was a period of especially rapid growth.

Graph 7

In summary, some of these explanations have more merit than others. External finance
is generally readily available and at very low cost, so this can't explain
the weakness in non-mining business investment. Looking at the available data,
it's hard to argue that heightened uncertainty is playing much, if any,
role. Rather, some combination of relatively low growth in domestic demand,
the effects of the high exchange rate, a lack of confidence and a lower appetite
for risk (than in the past) appears plausible. There are some metrics consistent
with this, and it aligns too with what businesses say is holding them back.

What Do the Data Suggest about the Future?

The Australian Bureau of Statistics capital expenditure (‘Capex’) survey
provides a measure of firms' investment plans for up to 18 months ahead.[10]

The most recent survey implies a modest increase in nominal non-mining business investment
in 2014/15, in the order of 4½ per cent. The survey suggests
that investment is likely to rise for a number of industries, including: rental
hiring and real estate; information media and technology; retail; and construction.
This picture is consistent with the ongoing recovery in household expenditure,
including on dwelling investment, and in non-residential building construction.
Investment is expected to decline in the manufacturing sector and for utilities.

Given that firms adapt their plans as events unfold, the early readings on investment
intentions for a given year often turn out to be wrong. We can see the extent
of this by comparing the early estimates for a given year with the final (seventh)
estimates in the Capex data. This is shown here based on the third estimate,
which is what we currently have to hand for this financial year (Graph 8). We can see that even over the course of just a few quarters,
business investment can turn out to be quite a bit higher, or quite a bit lower,
than the most recent reading from the survey suggests. For example, investment
covered by the Capex survey was much weaker than had been expected initially
through the 1990s recession and early 2000s slowdown. But it was stronger than
initially expected through the mid 2000s and a bit stronger than expected last
financial year.

In short, if firms decide to undertake more investment than they had earlier anticipated,
that investment can come about relatively quickly.

Graph 8

Conclusions

In conclusion, non-mining business investment has been subdued and measures of capacity
utilisation remain a bit below average levels. Meanwhile, over the past year
or so there has been a gradual increase in the pace of growth of economic activity
outside of the mining sector, owing in part to the very low level of interest
rates.

Subdued investment (outside the mining sector) has been consistent with a period
of greater uncertainty and below-average confidence. However, a number of indicators
suggest that uncertainty has declined to levels seen prior to the global financial
crisis. Also, measures of business confidence have picked up over the course
of the past year to be a bit above long-run average levels. While this is a
welcome development, it may not be sufficient to spur investment if businesses'
appetite for risk remains relatively low. Moreover, the still-high level of
the exchange rate may be weighing on investment of firms in the traded sector.

Nevertheless, there are tangible indications that non-mining business investment
will grow at a modest pace this financial year. And if firms' willingness
to take on risks improves, investment could easily be stronger still. It's
always hard to know if and when such a change in sentiment might occur. But
it is more likely to do so when the fundamental determinants of investment
are in place. The ready availability of internal and external finance, at very
low cost, is one element of that. The stronger growth of demand across the
non-mining parts of the economy over the past year or so is another. If history
is any guide, eventually the period of elevated risk aversion is likely to
give way to a concern among businesses, not of losses, but of lost opportunities
and a loss of market share.

Endnotes

It is worth noting that the period of weak non-mining investment up to 2012, and
non-mining activity more generally, allowed for the unprecedented mining
investment boom without leading to excess aggregate demand and all of the
problems associated with that.
[1]

The poor performance of Tobin's Q models is quite common in the literature. For
a discussion of some of the problems, see Chirinko R (1993), ‘Business
Fixed Investment Spending: Modeling Strategies, Empirical Results and Policy
Implications’, Journal of Economic Literature, 31(4), pp 1875–1911. For a
more recent discussion, see Roberts M and T Whited (2013), ‘Endogeneity
in Empirical Corporate Finance’, Chapter 7 in the Handbook of Economics of Finance,
2A, pp 493–572. The results of estimating these types of models on
aggregate Australian data have been generally disappointing (for instance,
see Cockerell L and S Pennings (2007), ‘Private Business Investment
in Australia’, RBA Research Discussion Paper No 2007-09). Some studies
that use firm-level data have had some success in modelling investment using
the Q ratio, but even these results are sensitive to certain modelling choices
(see, for example, La Cava G (2005), ‘Financial Constraints, the User
Cost of Capital and Corporate Investment in Australia’, RBA Research
Discussion Paper No 2005-12).
[2]

For a detailed discussion of the difference between these concepts, see Haddow A,
C Hare, J Hooley and T Shakir (2013), ‘Macroeconomic Uncertainty:
What is It, How Can We Measure It and Why Does it Matter?’, Bank of
England Quarterly Bulletin, 53(2), pp 100–109.
[3]

The measure in the top panel of Graph 5 is the S&P-ASX ‘VIX Index’,
which is based on option pricing data and measures expected levels of near-term
volatility in the Australian equity market; it includes mining sector stocks.
[4]

One thing that businesses often cite as a concern is uncertainty about various policies
affecting different industries. It's hard to judge, though, the extent
to which that source of uncertainty is greater today, if at all, than it
was in the past.
[6]

The saving rate has drifted down a little over the past couple of years, and the
stronger growth of household credit of late suggests that there has been
some pick-up in the appetite for risk among households.
[7]

For a discussion of the experience of US firms, see Sharpe A and G Suarez (2014),
‘The Insensitivity of Investment to Interest Rates: Evidence from a
Survey of CFOs’, Finance and Economics Discussion Series, Working Paper
2014-02.
[8]

In a related vein, there is evidence that Australian listed companies have more risk-related
meetings now than in the early 2000s. It's possible that this is a response
to an increased compliance burden, though such a change may have reduced
firms' appetites for risk nonetheless. (Special thanks to Gianni La Cava
for suggesting this measure and to Lara Bui who painstakingly constructed
it.)
[9]

The survey needs to be adjusted for the fact that realised investment tends to vary
predictably from what is initially expected by firms. There are various ways
to do this. For forecasting purposes, the most reliable method is to adjust
investment expectations by the average ‘realisation’ ratio over
the full history of the survey; for details, see Berkelmans L and G Spence
(2013), ‘Realisation Ratios in the Capital Expenditure Survey’,
RBA Bulletin, December, pp 1–6. It is also worth noting that
the Capex survey provides only a partial read on non-mining business investment
because it excludes firms from a number of key industries, including agriculture,
health care and education (which accounted for about 16 per cent
of private non-mining business investment in 2012/13) and it excludes investment
in intangible assets (which accounts for about 15 per cent of total private
business investment).
[10]